In the below post, we will discuss the somewhat recent holdings in Diversified Group v. United States and Larson v. United States, two cases dealing with whether or not promoter penalties under Section 6707 are divisible for refund claim purposes. An interesting issue, and one that may require a tweak to the law from Congress.

In September of 2015, Keith wrote about Diversified Group Inc. v United States, where the Court of Federal Claims held that shelter promoter penalties imposed under Section 6707 were not divisible, and therefore the promoter could not pay the penalty imposed on just one investor (this case was decided based on prior versions of Section 6111 and 6707, but the underlying concepts are still valid). In November, the Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims; the opinion can be found here.

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As explained by Keith and in the opinion, in general, a taxpayer can only sue for a refund in a district court after the amount of tax has been paid in full. SCOTUS created an important exception to this rule in Flora v. US, where it indicated an excise tax may be divisible based on each taxable transaction or event, allowing full payment to occur with a small amount of tax. Under Section 6707, certain promoters who fail to file required returns, or do so with a false or incomplete return, regarding reportable transactions are subject to penalties. The penalty then imposed was 1% of the aggregate investment amount (now the penalty is $50,000 for each transaction, or, if relating to a listed transaction, it is the greater of $200k or 50% of the gross income derived by the advisor (increased to 75% if the failure is intentional)). The promoter paid a portion related to one transaction and sued for refund, and the IRS objected. The lower court determined the penalty was not divisible, and was related to the singular act of failing to report the promoting of the tax shelter (and not the imposition of the amount on the 192 clients separate transactions).

The appellate court affirmed that the singular act of failing to report the shelter was what occurred to impose the penalty. Further, it reviewed the applicable language, finding the Code viewed the shelters in the aggregate (not individually) for determining if the penalty was applied, and Section 6111 required disclosure the day on which the shelter was initially offered, and did not relate to each investor buying in. Providing more evidence it was the initial failure and not each purchase of the shelter.

I quote briefly from Keith’s post regarding the direct impact of this case:

While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment. The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate. Maybe tax shelter promoters have access to that kind of money but most parties do not.

Keith’s post also discusses the potential for CDP as an avenue for a merit review by the courts, which is not without issues. If readers have not previously reviewed that aspect of Keith’s prior post, I would encourage them to do so.

The Diversified holding was followed by Larson v. United States, which was decided by the District Court for the Southern District of New York on December 28th. Larson is continued fallout from the KPMG tax shelter case from the mid-2000s. Mr. Larson paid a fraction of the $63.4MM Section 6707 penalty related to one transaction (the overall penalty was initially a $160.2MM penalty, but others paid portions of it). He argued that the partial payment was valid under Flora. The Southern District came to the same conclusion as the Federal Circuit.

Jack Townsend wrote up the case on his Federal Tax Crimes Blog here, where he summarizes the holding and quotes the salient aspects of the case. At the end of the post, Jack highlights his takeaways from the case, which include similar contents to Keith’s thoughts on Diversified. Jack thinks, given the huge dollar amounts that can be involved, that there needs to be some prepayment or partial payment review, otherwise taxpayers could be inappropriately precluded from litigating the merits. Mr. Larson attempted to make similar arguments in his case, based on the APA and the Constitution, which the Southern District did not agree with. These are discussed below.

Jack also highlights an APA challenge raised by Mr. Larson. Larson argued for judicial review under the APA claiming the denial of his refund claim was arbitrary, capricious, and an abuse of the IRS discretion. The Court found this argument lacking, stating “an existing review procedure will…bar a duplicative APA claim so long as it provides adequate redress. Clark City Bancorp. v. US Dept. of Treasury, 2014 WL 5140004 (DDC Sept. 19, 2014)”. The “existing review procedure” here was the full payment of the claimed amount due, and the request for review of a refund denial in the district court. Jack’s post highlights other language summarizing this holding.

There are various other interesting arguments made in this case. For instance, Mr. Larson argued the fines under Section 6707 violate the 8th Amendment of the Constitution (excessive fine, not cruel and unusual punishment, although if I told my wife I owed a fine of that amount I am certain it would result in cruel and unusual punishment). The Court questioned whether it had jurisdiction to review the matter, but eventually determined that didn’t matter, as Larson failed to state a claim.

Sticking with long shot Constitutional challenges, Mr. Larson also argued that his due process rights under the Fifth Amendment would be violated by the penalty under Section 6707 if it was not divisible because the imposition of the full payment rule would preclude him from being able to pay and therefore from being able to have a review. The Court rejected this argument, stating courts have consistently held that the inability to pay penalties has never been determined to be a due process violation (citing to various cases, including the recent case of his one-time co-defendant, Robert Pfaff, 117 AFTR2d 2016-981 (D. Colo. 2016)). I understand if this was not the rule, everyone would claim inability to pay, and it is possible that much lower fine amounts would clog the courts. Here, however, the fine was $63MM! I think less than .1% of the population would ever be able to pay that.

I have no further insight beyond what Jack and Keith stated. For the most part, the people arguing these cases have violated the tax law, and done so knowing full well that the areas they were flirting with had substantial penalties. They did this for significant financial gain. But, the penalties can easily be many times more than the assets of the individual, making it impossible for full payment, and there should be some way for the merits to be litigated. This will likely require a legislative change, although I am uncertain who is going to advocate for the tax shelter promoters.

Comment Policy: While we all have years of experience as practitioners and attorneys, and while Keith and Les have taught for many years, we think our work is better when we generate input from others. That is one of the reasons we solicit guest posts (and also because of the time it takes to write what we think are high quality posts). Involvement from others makes our site better. That is why we have kept our site open to comments.

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Leslie Book

Keith Fogg

T. Keith Fogg is a Clinical Professor of Law at Harvard Law School where he started a tax clinic in 2015. Prior to joining the faculty at Harvard, he began his academic career at Villanova Law School in 2007 after working for over 30 years with the Office of Chief Counsel, IRS. Read More…

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